Growth stocks refer to the stocks of companies which are in their growing phase and are expected to provide excellent results on a quarterly basis. These companies are generally future oriented companies which belong to a high growth sector. Such companies are always expected to produce great results which means that these companies often trade at a high P/E ratio (price to earnings ratio). To learn more about why some companies trade at a high P/E ratio , visit this article!
Growth stocks vs Dividend stocks
Growth stocks are companies which are generally younger and hungrier whereas dividend stocks are companies which are cash cows.
Growth stocks are companies which reinvest their profits back into the business because the company has the potential to grow even bigger. Such companies rarely (or never) give out dividends because that money can be used to grow the business even further which will generate even more profit in the future. Some examples of companies listed in NSE which are growth stocks are Avenue Supermart (DMart), Dixon Technologies, IRCTC, etc. These companies are ideal for youngsters in the stock market who are looking to grow their wealth.
Dividend stocks are generally companies which are past their prime and have very limited potential to grow further. Such companies pay out big dividends because they do not have any major expansion plans or the potential to grow the business further. These companies are generally efficient at generating profits & continue to do so while rewarding their shareholders in the form of big paychecks every quarter. Some examples of companies listed in NSE which are dividend stocks are Coal India, ITC, SJVN, etc. These companies are ideal for retired employees or experienced investors who are looking to conserve their wealth.
Why are growth stocks considered risky?
Growth stocks are generally considered riskier as compared to dividend stocks and are generally avoided by defensive investors. There are multiple reasons why growth stocks are risky.
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Trading at high P/E ratio
Growth stocks generally trade at a high P/E ratio because investors expect great results from the company. The entire idea behind growth stocks is that the stock is considered valuable even at high valuations because the company will grow quickly to justify the high valuations. But this is a double edged sword! A company which is trading at a high P/E has a very low margin of safety. Many defensive investors completely avoid such companies due to their high valuations. Just because many other investors are willing to overpay for the stock, doesn’t mean that you should too!
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One bad result can ruin it all
Growth stocks are able to justify their high valuations on the hope that the company produces excellent growth in their quarterly results. But what if the company has a bad quarter? Growth stocks get absolutely hammered in such situations because the mildly high valuations suddenly become exorbitantly high after a bad quarter which leads to a big sell off. So, the investor must have their eyes peeled for every single quarterly result of the company because even a slight disappointment in the company results can lead to a big loss.
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Speculators are more active in growth stocks
When a growth stock starts to trade at higher valuations, speculators become active in the stock hoping that the stock can trade even higher because of its growth. There is a theory which is called “The Greater Fool Theory” which can sometimes apply to growth stocks. This theory says that the price of an asset can keep on increasing as long as there is a ‘bigger fool’ to purchase for a higher price. This type of increase in price without improvements in the fundamentals can lead to a stock bubble which can erode a lot of investors’ wealth.
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Growth stocks are very volatile
Growth stocks are generally much more volatile than dividend stocks. The high activity of speculators combined with a huge demand for the stock because of its growth potential makes these stocks highly volatile. Unlike dividend stocks which are reasonably valued, growth stocks have a potential to be slightly overvalued to extremely overvalued. Many growth stocks (such as Avenue supermart, IRCTC, Dixon Technologies, etc.) have been trading at a P/E ratio higher than 100 (even reaching a P/E ratio of 200!) for long periods of time. So, there is a wide range of movement possible in growth stocks which makes them highly volatile.
Why are growth stocks important for an aggressive portfolio?
Despite its disadvantages, growth stocks are an absolute favourite amongst aggressive investors because of the many benefits they have.
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Volatility is great for aggressive investor
Volatility is the best friend of an aggressive investor. Volatility means that the market can be extremely bearish on the stock during bad times & that the market can be extremely bullish on the stock during good times. This provides a huge range in which the stock can trade which simply means bigger profit for the aggressive investor. Buying the stocks during a doomsday scenario & selling them during a euphoria is every investor’s dream come true!
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Growth stocks can provide great returns
Growth stocks can provide much higher returns when compared to dividend stocks because these stocks have a big potential waiting to be capitalized. Consider a growing business in an IT sector vs a sunset business (which is past its prime) in the coal sector. The growing IT business has a lot of potential to grow because the usage of technology is expected to increase in the future whereas the coal business is most likely to go downhill as the world switches from coal to a renewable source of energy. Growth sectors are the companies of the future & therefore can provide a much higher return when compared to dividend stocks. These stocks are also much more likely to become a multibagger due to their growing business and future potential.
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P/E re-rating
Many growing sectors can see a P/E re-rating where investors accept the higher valuation of the company because of its growth potential. A P/E rerating means that the stock price can rise without any change in the fundamentals of the company just because many investors accept the higher P/E ratio of the company to be the new valuation. However, continuous rise in P/E ratio without the backing of the fundamentals can often lead towards a stock bubble which is rarely sustainable in the stock market in the long term.
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Stock Market always rewards growth
The stock market loves growth. Investors are willing to throw money at companies even at absurd valuations as long as the company is able to demonstrate high growth. Growth is not only celebrated in the stock market but also in the economy. A new company growing at a 25% rate year-on-year has the potential to take over a bigger company which is growing at a 10% rate year-on-year very quickly due to the power of compounding. To learn more about the power of compounding, visit this article! Even a few percent of difference in growth can lead to massive differences in the company’s future. All the biggest large cap companies in Nifty today were (or still are) a high growth company!
Conclusion
Growth stocks are the highest potential stocks in the market which makes them ideal for aggressive investors. These stocks should be the prime focus for youngsters who are coming into the stock market to build their wealth. In fact, even defensive investors should have some exposure in growth stocks because these stocks have the potential to build the biggest wealth for the investors. Consider the US giants such as Google, Amazon & Facebook which have never paid any dividends. These companies kept on reinvesting in their business eventually becoming the giants which they are today meanwhile building massive wealth for their shareholders. However, an investor should also be aware of the euphoria which can happen in growth stocks and avoid becoming a ‘greater fool’ eventually eroding their capital!
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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